Does Debt Consolidation Hurt Your Credit Score?
At a Glance
Debt consolidation is a great way to eliminate high interest credit card debt, but how does that affect your credit score? Credit counselors will tell you that the loan is wasted effort if you don’t change your spending habits. Unfortunately, some folks don’t listen well and continue to use their credit cards after getting a debt consolidation loan. That will ruin your credit.
When you consolidate debt, you take out a new loan to pay down high-interest debt. In doing so, you are rolling all your payments into one monthly bill, ideally with a fixed interest rate. There are several ways to consolidate. The most common methods are personal loans and balance transfer credit cards.
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Will debt consolidation hurt credit score?
When you first consolidate your debt, your credit score could be temporarily negatively affected. However, keep in mind the positive impact will be better in the long-term.
Debt consolidation typically consists of opening a new line of credit, which will trigger a hard inquiry on your report. This can lower your score by a few points. Then, you’ll use that new credit to completely pay off some of your existing credit. This could potentially decrease your credit mix and age of credit, which could also temporarily lower your score. Increasing your credit utilization ratio could lower your score as well, so it’s important to try to keep that ratio as low as possible.
How debt consolidation affects credit?
Debt consolidation can both positively and negatively affect your credit, though negative impact is typically short-term:
1. Hard inquiry: A hard inquiry on your credit happens when you apply for new credit. Lenders do this to check your creditworthiness, and each hard inquiry can decrease your score temporarily. Multiple inquiries in a short period of time can have a greater impact.
2. Credit utilization: Your credit utilization ratio, which is the percentage of available credit that you’re using, makes up about 30% of your FICO credit score. The goal is to have utilization below 30%. If your utilization ratio increases after you consolidate debt, it could negatively impact your score. On the other hand, if you consolidate multiple credit card debts into one personal loan, your ratio could decrease and your score would improve.
3. Age of accounts: If you open new credit as part of consolidating debt, the average of your accounts will decrease and you could see a drop in your score.
4. Closing accounts: Closing a credit account after a balance transfer or debt consolidation loan could decrease your age of accounts or increase your credit utilization ratio, both of which could hurt your credit score.
5. Payment history: Payment history makes up about 35% of your credit score, so as long as you continue to make your payments on time, consolidating debt could help improve your credit score.
How debt consolidation helps credit score?
1. Amounts owed: One of the factors used to calculate your credit score is “amounts owed.” A debt consolidation loan will pay off those outstanding credit card balances all at once and put you on a system where you’re making a fixed monthly payment on the loan.
2. Payment history: You’ll have a set amount of time to pay the loan off, and each payment is reported to the credit bureaus. Make your payments on time and your score will go up as the balance comes down.
How to consolidate debt without hurting credit?
1. Use the funds to pay off your debt ASAP. Some lenders will pay your credit cards off for you when they approve you for a debt consolidation loan. If not, your best choice is to pay them yourself immediately. Get the money out of your hands before you spend it on something it wasn’t intended for. In some cases, there will be a few dollars left over when you’re done. Spend that if you like.
2. Pay your bills on time. Payment history makes up 35% of your credit score, so missing a payment can do fast, serious damage. Create and stick to a budget to make sure you have enough each month to make your payments, and enroll in autopay so you never forget.
3. Limit hard inquiries. Each time you apply for credit, the hard inquiry can impact your score. Do your research before applying to ensure you meet the qualifications, and get prequalified when possible (as that doesn’t impact your score).
What happens to the credit after debt consolidation?
What happens to your credit after debt consolidation will be determined by your spending behaviors both during the loan period and immediately following it. If you don’t use your credit cards and pay off the loan balance in full, your credit score should be in the “good” or “exceptional” range by the time you’re finished. If you’re still spending, it won’t be.
Ways to consolidate debt
There are several ways to consolidate debt, but the two most common are balance transfer credit cards and personal loans. If you’re a homeowner, you could also consider a home equity loan or home equity line of credit (HELOC). Both are secured loans, so interest rates should be lower. If you’re not a homeowner, choose one of the following:
1. Consolidate with a balance transfer credit card
Credit card companies looking for new customers sometimes offer an introductory period when you can transfer balances and get a 0% interest rate. That rate can last a few months, a year, or longer. If you feel you can comfortably pay off your outstanding balances in that time, this could be a good option for you. Search for “balance transfer credit cards” online.
Pros:
- A good or excellent credit score can land a lower interest rate plus 0% APR introductory period.
- Consistent payments can boost your credit score.
- Qualifying for a higher credit limit lowers your credit utilization ratio, improving your credit score.
Cons:
- A hard inquiry will temporarily impact your score
- Not repaying before the intro period ends means higher interest rates and payments. This can lead to missed payments, affecting your score.
- May increase your credit utilization, hurting your score.
2. Consolidate with a personal loan
Consolidating debt with a personal loan is a good option if you have multiple credit cards and outstanding loans. A personal loan to cover the total amount owed could lower your interest rates and condense all your debt payments into one single monthly loan payment. Interest rates on personal loans average roughly 9-10%.
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